Texas Roadhouse Analysis

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Texas Roadhouse is a casual full service restaurant chain. They are still relatively small at 330 company stores and 75 franchises. The stores are average size for the segment at 6,700-7,200 square feet. Unlike most chains, TXRH owns almost 40% of its locations rather than leasing all the properties.

Restaurantsand real estate

This model has certain advantages. Without a fixed rent, when revenue declines margins may better insulated from contraction when the firm fixed lease cost is not effectively leveraged (depending on amortization of the real-estate). The disadvantage is the initial capital spending is high and may prevent them from having sufficient funds to invest more profitably in the business—opening new stores for instance. Opportunity cost is a factor when large amounts of capital are tied up in real estate rather than the business itself.

When Texas Roadhouse owns the land, the cost to build is nearly 2X the cost to lease the land and build the restaurant. Think of it this way, TXRH could build two restaurants for every unit that requires them to buy the land. This is opportunity cost in expansion/enhancement of business as funds are tied up in acquisition of real estate. Real estate purchases are considerably slower than in the early years.

As TXRH flips the model in favor of more leased space, returns on capital have increased from 9.1% in 2007 to 13.3% in 2012. They have been accelerating leasing for only 5 years. In that time percentage restaurant additions have slowed as the base gets bigger, but the absolute number of adds has picked up after a drop during the recession 2008-2009. Capex spending consumes a much smaller percentage of cash flow since 2008 and free cash flow has been positive. All of these indicate that building new restaurants at the current costs and pace is not stressing the company’s capital structure and should be sustainable. Debt/capital is a low 8.9% and with $100 million in cash, TXRH should not need to sell shares or take on more debt to keep opening new restaurants.

Capex and locations

Capital expenditures will be $100.0 to $105.0 million in 2013 and most of it will be spent on new restaurants-- 28 in 2013. Operating cash flow is predicted to more than cover capital expenditures and the rest will be used to buy back stock, pay dividends, and/or repay debt.

The cost of building a restaurant sans land ownership is around $2.4 million including equipment. This is relatively cheap compared to other full service casuals at about half the cost but more than twice what a fast casual has to spend. It's not overly expensive to add new units and with ROIC at over 13% and cost of capital at 10%, spending is creating value. As real estate ownership becomes a smaller part of the costs, that should allow the company to build a few more restaurants with higher return on investment than owning a parcel of real estate.

Atmosphere and menu

There are 34 restaurants in Texas—the highest concentration. TXRH is in 48 states. They locate in mid-sized markets but with adequate population and demand to drive business. The restaurants are rustic almost fort-like on the exterior with interior décor southwestern ranch-style pine floors, western murals, Southwestern art, rugs and artifacts and lots of neon. They stress broad appeal, but with heavy emphasis on country western music on the juke box and line dancing, they are do not appeal to a broad range of diners. That’s not to say they won’t keep doing good business -- plenty of customers are looking for that experience.

The menu will also limit their appeal with the emphasis heavily skewed towards steak. Appealing to vegans is unnecessary –TXRH occupies a specific niche and does a good job. Steaks are the specialty and include almost every popular cut and fired up over gas grills. Fish, chicken seafood, pork and a vegetable plate are available for the non-steak crowd. TXRH serves alcohol and it’s 11% of sales.

The menu is consistently the same over time making them a predictable night out for returning patrons. A new item is added after exhaustive research gathered from guest feedback and evaluation of its profitability if added to the menu. When a new item is added, an old one leaves. They try to maintain 60 entrees. This is good management—large unwieldy menus are troublesome, unprofitable, unfocused and most often confuse customers and muddy a restaurants identity.

Prices are competitive for a full service restaurant with an average per guest check of $15.44. Fast casual is cheaper but a burrito at Chipotle (around $9-$10) is not directly comparable to a steak, potatoes, salad and dessert. It compares favorably to other full service restaurants—Olive Garden is $16.25-$16.75 and BJ’s around $13.

Growth has definitely accelerated in the past two years, but trailed off in Q2 2013 along with operating margins.

2012 average unit volume was $4.1 million. The time required for a new restaurant to reach a steady level of cash flow is approximately three to six months. Even though comps remained in line, a lower percentage of restaurants opened and average volume growth slowed slightly.

The growth isn’t spectacular with comp and unit growth in the mid-to-high single-digit range. Positive traffic growth is a plus even if comps are not stellar--positive comps relying only on price increases are unsustainable after a point. It’s not a bad pace but is insufficient to make Texas Roadhouse an incredible growth story. It’s difficult for full service to expand at anything close to the pace quick serve and fast casual can maintain. TXRH has solid but not spectacular performance.

TXRH margins stack up well against other full service, but as always, fast casual does better with lower expenses.

One thing the table tells us is the cost of sales ie gross #1 aka cost of food and packaging is very high for TXRH and reflects the emphasis on quality meat while Noodles relying largely on pasta comes in with high gross margins.

BJ’s was something of a surprise with the highest gross margins and the lowest cost of sales. Apparently it’s cheaper to make pizza and serve microbrews than serve steak. Granted that’s oversimplification—BJ’s has an extensive menu including sandwiches, pasta, salads and even steak. The point is that good meat is expensive and TXRH’s dinner-only menu relies heavily on quality meats. That impacts their gross margins. Gross #2 includes labor and even paying just one shift (dinner), they don’t make up the costs with reduced labor expense. If they served three meals and had more wait-staff, labor costs would likely create even lower margins and a dinner-only approach is a good idea. Of course serving lower cost breakfast and lunch could offset the high cost of dinner.

Where TXRH makes up ground is operating expenses. It manages excellent operating and net margins that compete with other full service restaurants. Darden is a good example of how aggressive national ad campaigns for Olive Garden and Red Lobster can result in lower operating margins. BJs has high occupancy and other restaurant operating expenses (utilities, common space, rent, insurance etc) TXRH probably benefits by being in smaller presumably less pricey locations. Texas Roadhouse rent average per unit is $81K(7,000 SF) while BJ’s averages around $210K(8,500 SF).

Finally

Texas Roadhouse strikes me as the sensible shoe of the full service restaurant space. They are a well-built, sturdy business, comfortable and longwearing. The capital structure and cash flow are solid and expansion is thoughtful and profitable. TXRH will not be the rocket to riches that a super-fast bullet train like Chipotle or Panera is. For that, you really need growth at 20%+ and comps in a high single-digit to low double-digit range to impress the market with the story. Texas Roadhouse is low-key, but growth should be steady and the price per share has the capability of at least gradual increase keeping pace with expansion. Expansion will be helped by TXRH taking on more low rent leases rather than buying real estate as they did in the early years. Using capital to open more stores and increase revenue and cash flow is a better use of cash when returns on capital are higher than costs of capital. TXRH ROIC is over 13% and cost of capital is 10%.

If the concept catches fire and comps inch up a few percent, it could outperform.

I am tempted to weed out some underperforming positions and replace stale investments with a small position in TXRH.